March 01, 2015 Real Property, Trust and Estate Law

Rents, Refi’s, and Reefer Madness

J. Marcus Painter

To real estate owners, legalization of marijuana has been the deus ex machina filling vacant industrial and retail space while the rest of the commercial real estate market languished in a world of tepid demand, tumbling rents, and expanding vacancies. Some lenders also saw it as a panacea for poor-performing loans during the Great Recession. But the initially curious anomaly of legalized marijuana in a few states has grown into a large economy across the country, which has opened a Pandora’s box of problematic legal issues for landlords and real estate lenders.

Federal regime. Marijuana is listed as a Schedule I narcotic under the Controlled Substances Act (CSA) of 1970; it is illegal to possess, grow, or dispense it or to conspire with or aid anyone else to do so (including renting space to, accepting deposits from, or securing a loan with property leased to a marijuana operation). The Comprehensive Drug Abuse Prevention and Control Act of 1970, as amended, and related federal statutes allow federal seizure of any real property used in conjunction with illegal drug trade, including property leased to such operations.

Legalization at the state level. Since 1996, 23 states and the District of Columbia have approved legal medical use of marijuana, through either popular vote or legislation. In 2012 Colorado and Washington legalized recreational as well as medical use of marijuana; Alaska, Oregon, and the District of Columbia joined them in 2015.

Attempts to reconcile federal and state laws. The public’s increasing acceptance of and comfort with some form of legal use is jarringly out of step with the federal laws on the books. As momentum has increased among the states to validate some form of marijuana use, so have efforts to bridge the chasm between state and federal laws governing the drug.

But while the proverbial camel’s nose of medical marijuana is well inside the political and public opinion tent, make no mistake: The “legality” of all medical and recreational marijuana businesses is a fiction existing only by the good graces of the Obama administration’s directives to the Justice Department to stand down on criminal or regulatory enforcement against marijuana businesses or individual users otherwise acting within the laws of their states. But the Obama administration clearly has no intention of pushing for marijuana’s legalization at the federal level, and until a new administration occupies the White House in 2017, one cannot know how strictly laws against marijuana operations or possession (and association with the same through the ownership of buildings housing such tenants or lending to such building owners) will ultimately be enforced. Until predictability is created by removing marijuana as a Schedule I narcotic, the risks of changes in policy, or that a marijuana operator’s conduct might cross the boundaries of the limited enforcement directives, loom large for real estate owners and their lenders.

Seizures and the innocent owner/lender defense. Both civil and criminal forfeitures are available to the government to enforce violations of the CSA. The ever-present and heightened risk of other criminal activity, coupled with raids and other enforcement actions, put a bank’s collateral and an owner’s property at frighteningly significant risk. Federal law not only permits the seizure of marijuana-related real estate assets but also the stripping of otherwise legitimate lien rights of lenders.

Banks’ and owners’ ability to fight seizure and retain their collateral and ownership positions is very limited. Once the government establishes a nexus between the property and the illegal conduct, the burden shifts to the owner or lender to show it is entitled to the innocent owner defense, which requires showing a lack of knowledge of, lack of consent to, or, once discovered, diligent efforts to terminate the illegal operation. Marijuana businesses (and their signage) are seldom hidden from a lender’s or owner’s view, so the viability of the innocent owner defense is largely illusory. Accordingly, the only truly safe approach for real property owners or lenders is to prohibit such conduct and undertake regular audits of their properties/collateral to ensure that none of the space is being used to “facilitate” a federal drug felony.

Anti–money laundering. Owners and lenders must also understand the risks associated with common “structured” transactions. The federal anti-structuring laws are designed to address the ruse of breaking down large monetary transactions into many smaller transactions to avoid reporting requirements or to hide a large and illegal transaction from detection. By necessity, structured transactions are the typical manner in which bank deposits are made and tenant rents are paid in the legalized marijuana economy. Landlords may be paid in cash or in a series of money orders and are then left to process these multiple, small-denomination payments into deposits with their bank—conduct that should result in the bank filing a “Suspicious Activity Report” (SAR) for that landlord with federal regulators (something that cannot then lawfully be disclosed to the landlord) or risk as individual bankers and banking organizations massive federal fines and personal imprisonment.

Rather than take such risks, banks instead notify the landlord of an “illegality” default because the loan payments are derived from the rents of an illegal marijuana operation. Banking lawyers are finding a growing workload in the area of default notices threatening acceleration and foreclosure if a marijuana-related operation is not removed from the collateralized real property.

Concerns for borrower-landlords. A borrower-landlord receiving such a default notice may face difficulties in simply evicting the offending tenant. Although banking law is generally federal, landlord-tenant law is not. A tenant being evicted on the basis of a federal law violation may well argue successfully in state court that federal banking issues are the landlord’s problem. The court may then rule that the landlord is estopped from seeking eviction because not only is the tenant’s operation lawful under state law, but at the time of leasing the landlord knew of and consented to the marijuana-related use. At that point, unless the landlord can use the lender’s acquiescence to the marijuana-related lease as a potential defense to the bank’s acceleration of the debt, a loan payoff or buyout of the tenant may become the very expensive, and only, options for avoiding foreclosure.

Adding to these risks is the mounting evidence with both grow and dispensary operations that the presence of marijuana plants, products, and processes can create significant impacts—structural, electrical, ventilation, and environmental—on the premises and beyond. These issues lead to large re-tenanting expenses that can impact replacement reserves, capital calls, and income covenants. They can also result in lower appraisals and loan curtailment payments to rebalance loan-to-value ratio covenants.

Landlords should broaden their right to terminate such leases via expanded default provisions covering issues including general nuisance, odor, illegal smoking or other consumption, criminal conduct, loitering, interference with other tenants, fire hazards, cancellation or increases in costs of insurance, violations of other tenants’ rights, increased utility costs, damage from operations, and more. But more effectively, landlords should install trap-door clauses in their leases allowing discretionary termination of the lease at the first sign of trouble.

Conclusion. Lenders and owners may have a variety of economic incentives to roll the dice with marijuana-related tenants. But in so doing, these lenders, owners, and their attorneys must be aware of the many criminal, civil, and financial risks involved.

ABA Section of Real Property, Trust & Estate Law

This article is an abridged and edited version of one that originally appeared on page 10 of Probate & Property, January/February 2015 (29:1).

For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

WEBSITE: americanbar.org/rpte

PERIODICALS: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, published three times a year; e-Report, bimonthly e-newsletter.

CLE AND OTHER PROGRAMS: Watch out for RPTE’s monthly CLE teleconferences; for more information, please visit our website.

BOOKS AND OTHER RECENT PUBLICATIONS: A Practitioner’s Guide to Real Estate and Wind Energy Project Development; Handbook of Practical Planning for Art Collectors and Their Advisors; Fundamentals of Title Insurance; A Guide to International Estate Planning, 2d ed.; The Advisor’s Guide to Life Insurance; The Commercial Lease Formbook, 2d ed.; The Insured Stock Purchase Agreement, with Sample Forms, 2d ed.

J. Marcus Painter

J. Marcus Painter is a partner with Holland & Hart LLP in Boulder, Colorado.